What Is a Simple Interest Loan? An Easy Guide
Written by
John Csiszar
Edited by
Melanie Grafil
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A simple interest loan doesn’t charge you additional interest on your accrued interest. In other words, the only interest you pay is on the outstanding principal balance of your loan. Auto loans and personal loans most often charge simple interest. All else being equal, you’ll usually want to take out a loan using simple interest, as it will cost you less.
The term “simple interest” usually means “daily simple interest” in finance. For this article, simple interest will be explained in terms of daily simple interest. Here’s how simple interest loans work.
How Does a Simple Interest Loan Work?
A simple interest loan charges interest on the original principal, without compounding. Payments go towards your interest first, with any remaining amount going towards your principal.
One of the key benefits of a simple interest loan is that if you pay early or make extra payments, it reduces your total interest costs. This is because your interest is calculated daily on your remaining principal. With a smaller remaining principal balance, your interest costs will also be reduced.
How To Calculate Interest on a Simple Interest Loan
Here’s the formula for simple interest:
- Interest = Principal x Interest Rate x Time
Imagine, for example, that you have a 3-year, $10,000 loan with an interest rate of 5% annually. Based on the formula, you might expect your interest calculation to look like this:
- Interest = $10,000 x 0.05 x- 3 = $1,500
- Total Repayment = $11,500 ($10,000 original balance plus $1,500 in total interest)
However, for most real-world applications, daily simple interest is used. As a daily simple interest loan only charges interest on the existing principal value, not the value of the entire loan, you won’t pay $1,500 in interest on this type of loan. The actual amount of interest you pay will depend on the size and timing of your payments.
If you make regular monthly payments of $299.71, for example, your loan will be paid off in 36 months and you will have paid $789.54 in total interest, not $1,500. This is because your principal will be declining the entire time. After one year of payments, your principal balance will be $6,831.54, and after two years, your balance will be $3,500.95. The interest you owe will decline with every payment you make.
Simple Interest vs. Compound Interest Loans
Simple interest loans are very different from compound interest loans. They are also generally used for different types of loans. Here’s a look at the main characteristics of the two types of loans, side-by-side:
| Feature | Simple Interest Loan | Compound Interest Loan |
|---|---|---|
| Interest calculation | Based only on principal | Based on principal and accumulated interest |
| Total interest cost | Lower | Higher over time |
| Common uses | Auto loans, personal loans | Credit cards |
| Best for | Borrowers who want predictable payments | Long-term financing |
Pros and Cons of Simple Interest Loans
Simple interest loans have some obvious benefits, but they also have drawbacks.
Pros
- Easier to understand and calculate
- Lower total interest compared to compound interest loans
- Can save money by making early or extra payments
Cons
- Interest is front-loaded, meaning early payments mostly cover interest.
- Missing payments can increase the total interest paid.
- Less common for long-term financing.
Types of Loans That Use Simple Interest
Simple interest is most commonly used with these three types of loans:
- Auto loans: Most car loans use simple interest to keep payments predictable.
- Personal loans: Many short-term personal loans follow simple interest.
- Short-term installment loans: Used for small purchases or quick cash needs
How To Pay Off a Simple Interest Loan Faster
With a simple interest loan, the more you pay, the less interest you owe. Here are some ways you can pay off a simple loan faster:
- Make extra payments to reduce the principal and lower total interest.
- Pay early in the month to reduce daily interest charges.
- Set up biweekly payments instead of monthly to make an extra payment per year.
Final Thoughts: Is a Simple Interest Loan Right for You?
Simple interest loans are best for borrowers who want predictable payments and lower interest costs. They work well for auto loans and short-term financing. As a simple interest loan only charges interest on your principal balance, not any accrued interest, it costs less than a compound interest loan. However, it can be hard to tell between the two, which is why you should always check a loan agreement to ensure it follows simple interest rules before you sign it.
FAQs About Simple Interest Loans
Here are answers to some of the most frequently asked questions about simple interest loans.- How is a simple interest loan different from a mortgage?
- Most mortgages calculate interest due monthly, whereas simple interest loans calculate the balance daily. This means that making an extra payment 29 days early will save you 29 days of interest on a simple interest loan. With a mortgage, however, an extra payment made 29 days early has the same effect as one made one day early, as the interest is only calculated on the monthly balance, not the daily balance.
- Can I save money by paying off a simple interest loan early?
- Yes. The faster you can reduce your simple interest loan balance, the less interest you'll have to pay.
- Do banks offer simple interest personal loans?
- Yes, most personal loans offered by banks are computed with simple interest.
- What happens if I miss a payment on a simple interest loan?
- Typically, a late payment on a simple interest loan will result in penalty fees and a negative mark on your credit report. You'll also owe more in interest, as a simple interest loan calculates interest due based on your daily balance.
- Are student loans simple or compound interest loans?
- All federal student loans are simple interest loans. Most private student loans are also simple interest, but you'll have to check the terms of your loan to be sure.
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- Capital One. "What is simple interest and how does it work?"
- Consumer Financial Protection Bureau. "What's the difference between a simple interest rate and precomputed interest on an auto loan?"
